The Debt Dilemma
A balanced approach allows you to serve today’s needs while preparing for tomorrow.
Paying down debt is often difficult, and even more so in a challenging economic environment. You may be wondering which to tackle first – pay down your debt or invest for the future?
Balance Is Best
A balanced approach to wealth management serves both today’s needs and tomorrow’s goals. For some that may mean paying off some debt today while simultaneously investing for the future.
Your own needs and circumstances will be unique. The following guidelines can help you evaluate alternatives and find an approach that fits your situation and goals.
Don’t Forget Your Emergency Fund
In addition to paying down debt and settling on an investment strategy, make it a priority to set up an emergency reserve. Traditional “rules of thumb” suggest setting aside three to six months or more of living expenses in traditional savings or very short-term, highly liquid, low-volatility investments.
While ideal, that goal may not be realistic for everyone. Start by building up a reserve of a month’s expenses, and make it a goal to increase your emergency fund over time as resources permit.
Your Future First
When making decisions about debt and investing, be a long-term thinker. Consider “what position do I want to be in 10 or 20 years from now?” Then evaluate what actions today will be most effective in helping you achieve your long-term financial goals.
For example, if you have high-interest debt that is compounding, this could eventually become a serious impediment to reaching your long-term goals. In contrast, you might not be in a hurry to retire low-interest debt, if the potential return on long-term investing would be greater.
When making decisions about debt reduction vs. investing, keep in mind that the need to eventually pay off principal is certain, but investment returns are not. Investment performance will vary over time, and it’s possible to experience losses as well as gains. At the same time, it is well known that investors who start earlier benefit from compounding and “time in the market.”
If you have the opportunity to participate in a retirement plan at work, and your employer makes matching contributions, that could be a compelling reason to prioritize investing up to the amount that the employer will match.
But there are no magic numbers. That’s why it’s important to work with your financial advisor to create an investment strategy that fits your financial expectations for the future.
Prioritize Your Debts
With your emergency fund and investment strategy in place, you can begin deciding on a strategy for reducing your debts. But how do you decide which debts to pay down first?
Mathematically, it makes sense to focus on paying off high-interest debts like private student loans and credit card debt first. Federal student loans and mortgages might be lower priorities because their rates are often lower and their terms longer. Vehicle loans might fall somewhere in the middle. Tax considerations may also come into play.
An alternative approach is to start with the smallest debt first. It might be motivating to get a “quick win” by paying off a smaller debt before beginning to chip away at a larger one.
Once you pay off one debt, add that payment amount to a different debt payment amount to accelerate its pay off.
One last tip: Don’t discount your emotions. If paying off a certain debt will help you feel more secure, follow your gut. Or discuss with your financial advisor before you decide. Also, identify some key milestones that you want to reach, and celebrate (modestly) when you achieve those goals!
- Examine your personal budget. Determine how much you owe in monthly minimum payments and in total.
- Make sure your emergency fund is well-funded.
- Work with your financial advisor to create an investment strategy.